On 28th March, the Securities & Exchange Board of India (SEBI) made headlines for partly accepting the Kotak committee’s recommendations on corporate governance. However, its decision on “measures to strengthen the algorithmic trading framework” has apparently stirred up a hornets’ nest in its newly reconstituted Secondary Market Advisory Committee (SMAC). According to an anonymous letter, claimed to have been written by an SMAC member, the decisions on algorithmic (algo) trading, announced by SEBI after its board meeting, are completely contrary to the recommendations of the SMAC as well 95% of the comments received by the regulator to the discussion paper published 18 months ago.
Algorithmic trading (algo trades) is a high-speed automated trading that generates large volumes and uses complex mathematical algorithms.
The manipulation of algo trading at the National Stock Exchange (NSE), which was revealed to me in another anonymous letter by a whistleblower, had eventually led to a detailed investigation and forced a clean-up of the NSE’s top management and marked the genesis of this discussion.
Hence, it is ironic that the SMAC member should choose to copy his letter to me and it is rather ridiculous that the regulator, once again, chose to remain silent, despite repeated our efforts to get its view. SEBI’s actions raise questions about how the regulator chooses to operate.
Let’s start with SEBI’s announcements after its board meeting on 28th March, on this issue. There were several excellent decisions taken that day to increase transparency in algo trading, including the testing of algos and publication of data. The contentious issue is physical settlements for derivatives. SEBI announced a phased and calibrated switch to a physical settlement for all stocks in the derivatives section, in order to ‘facilitate greater
alignment of the cash and derivative market’.
It changed the criteria for selecting stocks for the derivatives segment; revised the market-wide position limit from Rs300 crore to Rs500 crore and the median quarter-sigma order size from Rs10 lakh to Rs25 lakh. Eligible stocks must also have an average daily deliverable value in the cash market of Rs10 crore; this criterion needs to be met continuously for six months. Stocks that are currently in the derivatives segment but fail to meet such enhanced criteria would be physically settled.
Any stock that fails to meet the enhanced criteria within one year or fails to meet any of the current existing criteria continuously for three months, would exit the derivatives segment. Stocks that are currently in derivatives and meet the enhanced criteria would continue to be cash-settled, as now. But, if any stock fails to meet any one of the enhanced criteria for a continuous, three-month period, it will be moved from cash settlement to physical settlement. If it still fails to meet the existing criteria for three months, it would exit from derivatives. After a period of one year, only those stocks which meet the enhanced criteria would remain in the derivatives segment.
SEBI wants to limit trading in derivatives to individuals on the basis of a sum computed on their disclosed income-tax returns. Intermediaries will be made to “undertake rigorous due diligence and take appropriate documentation from the investor.” An anonymous whistleblower, claiming to be an SMAC member, says that SEBI’s decisions are completely against the recommendations of SMAC, where most members, including the chairman, were of the view that the measures announced by SEBI would, in fact, ‘kill the derivatives market’ and, at the same time, not help improve the cash segment.
He says that Prof JR Varma, who chairs the committee, was not only against compulsory physical settlements, but “scathing of the proposed income-based exposure in the derivatives trading by the retail traders.” He further says, the SMAC was told that ‘over 95% of the public comments’ on the discussion paper were against the proposed measures. He points out that if SEBI ignores SMAC as well as public comments, why have the farce of conducting such an exercise at all?
According to the whistleblower, the move will result in reducing the trading volumes at the Exchanges and impact tax collection and fee income of the government, bourse and regulator (turnover fee, etc). He claims that Prof Varma was also against the ‘risk management framework proposed by SEBI’, on the grounds that ‘it would significantly increase cost for the small and large investors alike and would not curb but increase fraud’.
Interestingly, the regulator’s press release on 28th March only said that the SEBI Board “took note of discussion papers titled “Growth and Development of Equity Derivatives Market in India” and “Physical settlement in stock derivatives”, public comments received thereon and also recommendations of the SMAC. There was no comment on whether or not it has accepted SMAC’s recommendations or taken into account views in the public comments.
I wrote to the SEBI chairman and all official members on the SMAC to get details. SEBI, as usual, did not bother to reply. I emailed Prof JR Varma, who is on a holiday and not accessing his email regularly. However, discussions with people connected with the issue indicate that the SMAC chairman and some members were, indeed, against the proposals and blunt in their views. Nobody would confirm whether SMAC has formally recorded its objections. It is also a fact that SEBI’s action on the demand for physical settlement in derivatives is a long-pending one; but other issues are more complex.
SEBI’s decisions, while making the derivatives segment fairer for smaller retail investors, could lead to a drop in derivatives’ turnover, especially on the NSE, which is currently a near-monopoly. There may be a commensurate reduction in tax collection too. How steep will the fall be? Will it drive away large, institutional algo traders, who contribute to the bulk of frothy volumes generated by machines, to other geographies? What will be the impact on India’s standing among world markets? Is there any plan to encourage margin funding or stock lending and borrowing mechanisms? How exactly will SEBI’s actions improve investor safety? We have no answers.
SEBI is certainly not bound to accept the recommendations of the SMAC. However, it would have been prudent for a regulator to have placed on record its reasons for rejecting the SMAC’s advice and to indicate that it has taken into account the possible negative fallout of its actions. One also has issues with SEBI’s attempt to dictate investor behaviour by attempting to restrict trading to a formula based on tax payments.
Worse, its attempt to dump the task of monitoring investor actions on brokers is not only unfair, but ludicrously impractical; it will increase costs and create further barriers to investing in the capital market. Surely, SEBI’s job is not to restrict and limit investment in the capital market so that its job of regulation and supervision is made easier. It is high time the SEBI chairman’s job defined key result areas, with expanding and deepening capital markets right at the top with investor protection.
The manner in which SEBI’s meetings are conducted is also open to question. The Kotak committee on corporate governance drew dissent notes from key members, after the report was ready for submission. This time, there are allegations that the SMAC’s recommendations were ignored; the whistleblower’s letter also has a long rant imputing motives to a SEBI official; this raises questions about the kind of people who find representation on SEBI’s committees. In the past few years, SEBI chairmen have quietly dispensed with the token representation to investors (who are the largest stakeholders), on most committees. All this does little to inspire confidence about regulatory accountability.
