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Algorithmic trading in Indian markets
Read more on - Polity | Economy | Schemes | S&T | Environment
- Secretive and super-fast: Split-second, high-precision algorithmic trading is on the rise in India. It’s controlled by a secretive community of tech and market wizards who like to lie low - some names are - Hudson River Trading, Virtu Financial, Tower Research Capital, Jump Trading, Getco, Progress Apama, FlexTrade Systems etc.
- Unknown and huge: Not many have heard about these firms. These are global majors doing business worth hundreds of millions of dollars in India in the highly-secretive world of algorithmic trading in stock markets.
- Algorithmic trading: It is also called "algos" in market parlance. It refers to a software designed to execute trading strategies, in a fraction of a second, which is impossible manually. In the world of algos, the speed at which the trades are executed is of paramount importance. A split-second delay and the potential gains could be significantly reduced.
- A code is written to automatically trigger a buy or a sell trade when, for instance, the price of a certain share goes below or above a predefined level. It could also be designed to capture the small difference in the share price of a company on the BSE and National Stock Exchange, known as arbitrage gains in market jargon.
- Far more complex and sophisticated algos are now used by the deep-pocketed global and even domestic institutional investors and brokerages.
- Large Indian brokerages like Edelweiss Securities, IIFL, Kotak Securities and Motilal Oswal Financial Services among others also offer algo-based trading facilities. They service foreign and domestic institutional investors who prefer algos to execute strategy-based trades in India.
- Global majors are seeing a consistent rise in trading, but remain tight-lipped about their activities to avoid attracting undue regulatory or media attention.
- Regulators unhappy: Globally, regulators view algo as a very high-risk trading mechanism and hence algo firms do not like to talk much about their business activity. Global players use smart and sophisticated algos in India, which now offers a decently deep market to put their algos in play. It is believed that nearly 70% of the daily turnover is attributed to algos. That is a pretty large share, given that algo trading was allowed in India only in 2008 (though market regulator SEBI has barred the use of algos for retail investors).
- Co-location issues: Orders from co-location services — wherein the broker keeps his server close to that of the exchange to reduce the latency in order execution — use algos, as do direct market access (DMA), where the investor can directly send the order to the exchange through the broker’s terminal but without any manual intervention at the broker’s end.
- The buy-side players like mutual funds often use algos to rebalance their portfolio that might run into thousands of crores.
- Algos will slice the order and keep executing it in parts so as to keep the impact cost — the cost of executing a trade — low while also minimising the probability of front-running that would attract the regulator’s ire.
- Front running is an illegal way of trading in shares based on the insider knowledge of an institutional trade that would influence the stock price.
- Most large Indian brokerages now see over 80% of their institutional turnover emanating from algos.
- Dangers: On 13 March, 2020, the benchmark indices hit their 10% lower circuit limit and, as per regulatory norms, trading had to be halted for 45 minutes. Once trading resumed, the benchmarks staged an unprecedented rally to gain over 4,700 points. What caused such a rally?
- Buying after the huge fall was triggered by algos that were programmed to initiate buy or sell orders based on the S&P 500 levels. Incidentally, there was huge volatility in the US markets as just a day earlier, the US Federal Reserve announced a trillion-dollar worth stimulus package.
- On 31 May, 2019, in less than 30 minutes, the Sensex witnessed a sharp and sudden 700-points fall, which was again due to some algo trades gone sour. (c) There are many such instances. In 2011, all the trades done in the equity derivatives segment of BSE during the special Muhurat trading session were cancelled due to an algo trading mishap.
- SEBI's checks: One of the checks put in place is order-to-trade ratio, which refers to the total number of orders being sent by the algos to the total number of orders executed. A lower order-to-trade ratio attracts penalty as it means that the triggers set in the algo are not in sync with the current market prices.
- According to the Indian regulatory framework, any algo before being introduced in the market has to be approved by the stock exchanges and the Securities and Exchange Board of India (SEBI) as well. This minimises the probability of a rogue algo disrupting the safety of the markets.
- The danger is accentuated because the bulk of institutional trading is done through software codes and without any manual intervention.
- There are simple execution algos that institutional brokerages offer their clients. There is alpha-generating algos that hedge funds, arbitrageurs and proprietary desks use.
- Secrecy: There is no public database of algos as such and no firm would talk about their algo strategies publicly. No one would know what are the kind of complex algos being used here. Developing an algo costs a lot and if the secrecy element is lost then the advantage would also be lost as someone might just try to replicate the model. Developing an algo requires a team of highly skilled persons. Algos require co-location facilities too and hence firms need to budget that as well. According to market participants, the annual cost for co-location starts from around Rs. 6 lakh and could go up to ?15 lakh or even more depending on the number of servers to be kept in the exchange premises.
- Summary: Algos have gained immense popularity and acceptance in most markets globally, but there are risks associated. In India, SEBI has barred the use of algos for retail investors. The proprietary desks of brokerages are using algos to design trading strategies. There is no explicit ban on retail investors creating and testing strategies in the back end and then executing it through any regular broking platform.
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