High-frequency trading is causing more and more concern, especially among global regulators
High frequency trading (HFT), through computer-generated algorithms, is something that few retail investors are even aware about, despite its massive role in our equity markets. According to a discussion paper of the Securities & Exchange Board of India (SEBI) in 2013, HFT accounted for a massive 94% of all trades in the equity derivative segment in a single month—February 2013—on the largest exchange. Stock exchange sources say that the percentage is probably higher today across the two national exchanges. HFT is automated trading conducted at microsecond speeds throughout the trading day. Large traders execute this by renting space to locate their servers within the stock exchange premises in order to get the benefit of faster transaction speeds. What are the implications of such trading?
According to a briefing note of the senior supervisory group (SSG) of global market regulators, put out in April 2015, “The risk that HFT activity specifically, and algorithmic trading more generally, poses to firms and the financial markets has sparked debate and raised concern among market participants and regulatory agencies globally.” The SSG comprises market supervision agencies from 10 countries and the European Union.
The concerns expressed by the group are:
Systemic risk is amplified and an error with an algorithm, at a relatively small firm, could cascade throughout the market.
Technology failures, exceptional or unanticipated market conditions could lead to a firm carrying significantly more risk overnight than it had intended, and without timely oversight.
Internal controls may not have kept pace with market complexity. More specifically, the note says, “malfunctions and outages at financial institutions and critical entities such as exchanges are not new, but their potential impact can be amplified.”
Losses can accumulate rapidly in the absence of adequate controls. The SSG note cites examples such as the “2010 Flash Crash (a large-order execution algorithm operating in an unexpected way), the 2012 Facebook IPO (an exchange system problem), and the 2012 Knight Capital incident (the malfunction of an order routing system).” The note says that regulatory action that followed these incidents “highlighted control shortcomings related to insufficient testing and new rules.”
Apart from international regulatory concerns and greater scrutiny of HFT trading, faster access to some traders has become a matter of litigation. According to a report in The New York Times, a group of large pension funds has filed a suit alleging that stock exchanges favour high-frequency traders at the expense of other investors. The pension funds allege that exchanges offer a number of paid services used by high-frequency traders, including detailed data feeds, special types of orders and the ability to place computer servers in the exchanges’ data centres. Thus, the exchanges have a “financial incentive to create an uneven playing field.”
In India, the first reporting requirement on SEBI’s new guidelines for HFT trading with additional checks & balances was issued in May 2015. These reports are due for the September quarter. While HFT was earlier available only to large traders who could pay hefty costs, fees and rent in the region of Rs40 lakh per annum, media reports suggest that it will be extended to smaller brokers with shared server space. Does this mean that SEBI has found an answer to all the issues that are of concern to global regulators? We don’t know; because the market watchdog gets away with generalised threats or instructions but remains unaccountable when it comes to specifics.