Can SEBI be bold, turn markets organic?

In the corridors of markets in Mumbai, three names are in high circulation. SEBI (Securities and Exchange Board of India) chairman Ajay Tyagi, whole time member SK Mohanty and Executive Director Nagendraa Parakh.

The buzz is simple but strong. That this troika could have done a lot to stem the rot in the NSE (National Stock Exchange of India) co-location scam but did nothing and squared up the tables, reminding many of the Cotton-eyed Joe song of the American Civil War that stretched between 1861-65. In short, you see many things, know everything but still do not react.

And now, the very probe — ridiculed by many as a desktop investigation — and the clean chit to top officials of NSE who were allegedly involved in the co-location scandal and even indicted by SEBI and fined Rs 1,000 crore, is making many sit up and take notice.

Everyone is asking: Why, why, why did the SEBI remain silent?

Among the voices, the one that was most powerful was that of Ashok Jhunjhunwala, chairman of SEBI’s technical advisory committee who raised the issue of preferential access to select clients for executing market orders and its dangerous impact on the market. Speaking at an event organised by SEBI and National Institute of Securities Markets (NISM), Jhunjhunwala made it clear that both co-location and high-speed trading were prone to manipulation and fraud, and that traders could game the system in connivance with market players to get faster access to price-sensitive information. He said this was a serious issue which the capital market regulator had grappled with time and again.

“Price-time priority is the mantra of any exchange, which basically says that orders will be executed strictly on ‘first come first served’ basis. But is there fairness in processing? Does every customer get a fair chance to execute the order based on price-time priority?” asked Jhunjhunwala, also a professor at IIT Madras. He said the principle of price/time priority refers to how orders are prioritised for execution. First, orders are ranked according to their price and orders of the same price are then ranked depending on when they were entered. “Today all technology systems have multiple gates and each of them have separate queues. It’s very difficult to say that price-time priority is being strictly followed,” Jhunjhunwala said.

Jhunjhunwala said the process was prone to cause gaps, not healthy for the markets. Consider the case of a person from a state in the North East who may take longer in reaching the exchange gate than someone in Mumbai. Now traders close to the Exchange building will reach the entry gate faster and it is needless to mention that co-location computers within the Exchange will be the fastest. So there is a clear cut anomaly. “Co-location and high speed computers can place thousands of orders in 10 milliseconds. So if I am in Chennai and place an order in say 5-8 milliseconds, someone with a co-location facility can place thousands or orders in that time,” said Jhunjhunwala, adding: “So, traders are spending huge amount of money to stay micro or nano seconds away from the exchange leaving those who trade in milli-seconds, or in seconds far behind. This is basically unfair.” For the record, one second is equal to 1,000 milli seconds and 1 milli second is equal to 1,000 micro seconds. 1 micro second is equal to 1,000 nano seconds. “There is a tendency to cheat and manipulate if I can get ahead of others and make more money,” said Jhunjhunwala, adding that the challenge was to increase liquidity without compromising on fairness.

Let’s not forget algo and high-frequency trading contribute about a third of market volumes in India.

Those who pushed colo or high-speed trading argued that it boosted liquidity and encouraged investor participation, especially from institutional investors. Be that as it may, the exchange has a bias in promoting such trades considering that such activity is monetarily rewarding for the exchange, observed Jhunjhunwala.

His comments came at a time when SEBI said NSE officials did no wrong and absolved them of all charges. Denial of service by intermediaries such as brokers, particularly if done deliberately, was another serious issue that the regulator needed to look into, warned Jhunjhunwala.

But still, SEBI gave all a clean chit. The list of those exonerated include Ravi Narain (former MD & CEO), R. Nandakumar (former senior vice president, VP for operations), Mayur Sindhwad (chief operating officer, COO for trading), Sankarson Banerjee (chief technology officer, CTO for projects), G. Shenoy (CTO for operations), Suprabhat Lala (vice president, regulations), Ravindra Apte (former CTO), N. Muralidharan (former CTO) and Jagdish Joshi (former head for Colo). And this happened after five years after a whistleblower’s letter was published in Moneylife newsmagazine about the alleged scandal, the issue is back to square one. And now, the SEBI order says nothing was done to cause unfair advantage and there was nothing in the system through which brokers could make crores of rupees of illegal profit.

So how does one handle the issue. For example, if the market goes up and investors cannot sell, it’s a lost opportunity. It is known to many that the Technical Advisory Committee of SEBI had, in its 2016 report, concluded that there were systemic lapses at the NSE, and had asked the market regulator to probe ‘collusion’ at different levels in the exchange. This is on the record and very, very fundamental to market. Said a top hand of an exchange: “We don’t want only organic food and medicine but also organic markets. If price and time is sacrosanct the access and nature of access should ensure that all have similar time and price. By letting some at high speed, high frequency and colo, we are making markets inorganic to its basic assumption. The issue of organic nature of price and time is not relevant only at the time of matching trade but also at the time of inputs and outputs into the system as these price streams decide the priority and ranking of where a price will be ranked and with what time stamp it will be ranked.”

Jhunjhunwala raised the same issue, saying algo and colo create price and time disadvantage to many at the cost of few in creating a queue which is always advantageous for those who can change prices more rapidly using Algo and then communicate it more quickly to the queue versus the rest of the market due to time and speed advantage. Now, the matching trade prices and time would have been different if all had the same speed and time. 

So what happened. First, manipulation took place in creating the price and time queue by those in algo and colo versus the rest of the market. Secondly, manipulation took place in reacting to a market price and at a time as the broker in algo plus colo could react faster then what the rest of the market could see based on naked eye versus the system reading algo. It was clear that the queue was dominated in price and time by algo and colo users and the rest of the market was crowded out in the queue time and price.

“If we can generate a simulated queue devoid of colo and algo orders then we will see that the price discovery which would be based on equivalence and it will be at a very different price and time and also between different set of counter party then what was achieved during colo and algo queues vowing out the organic market users,” said the official, speaking on conditions of anonymity.

And this is not an Indian syndrome. A new study, first printed by the globally acclaimed Wall Street Journal said high-frequency traders earn nearly $5 billion on global stock markets a year by taking advantage of slightly out-of-date prices, imposing a small but significant tax on investors. The study by Financial Conduct Authority, the UK’s financial regulator, shed ample light on a controversial practice called “latency arbitrage,” in which ultrafast traders seek to react to fresh, market-moving information more quickly than others can. 

“Such information could range from corporate news to economic data to price fluctuations in other stocks or markets. Electronic trading firms invest in sophisticated technology, such as networks of microwave antennas linking exchanges thousands of miles apart, to process such information and execute trades in millionths of a second,” said the study.

Interestingly, the FCA’s study came around the time politicians in both Europe and the US, including Senator Bernie Sanders and Senator Elizabeth Warren pushed for a financial-transaction tax, a policy aimed in part at curbing high-speed trading. The study could also fuel efforts by exchanges to restructure their markets to limit latency arbitrage—for instance, by introducing split-second delays before trades, popular as speed bumps.

Experts claim latency arbitrage raises costs for investors by making everyone in the markets less likely to post competitive price quotes for stocks, knowing such quotes could get picked off by speedy traders. It means investors get slightly worse prices whenever they buy or sell shares. 

Although that is a tiny number—less than one-half of one-hundredth of 1%—the study’s authors say it adds up. If latency arbitragers made a similar rate of profits elsewhere, they would have earned $4.8 billion on stock exchanges around the world in 2018, including $2.8 billion at U.S. exchanges, said the FCA study.

The study, said Wall Street Journal, found that about one-fifth of trading activity at the London Stock Exchange was concentrated in brief “races” between firms seeking to engage in latency arbitrage. In such races, two or more firms attempt to trade the same stock at the same time, but only the first can profit by being the quickest to execute its trade.

During the period examined in the study—43 trading days from August to October 2015—about 22% of trading volume in FTSE 100 stocks took place in such races, which on average lasted 81 millionths of a second, the study found. The FTSE 100 is the UK’s large-cap index, with companies as BP PLC and Vodafone Group PLC.

The FCA’s study relied on more than 2 billion electronic messages that trading firms sent to the LSE, or that the exchange sent to traders, during that period. 

Such data—which hasn’t been used in past studies of latency arbitrage—showed failed attempts to trade as well as actual trades. That allowed the authors to reconstruct the tiny bursts of activity in which multiple firms raced to seize the same brief profit opportunity.

The data also showed only a few firms can profit from latency arbitrage, a finding that likely reflects the cost of building and maintaining the technology needed for ultrafast trading. More than 80% of races in FTSE 100 stocks were won by the same half-dozen firms, the study found.

Is SEBI listening?