[By Ananya Sahu and Ketan Priyadarshee]
The authors are students at Maharashtra National Law University, Aurangabad.
High-Frequency Trading (HFT) is a wide term with no precise definition in any statute. It is usually explained as a subset of algorithmic trading that uses “latency-sensitive strategies”, “co-location”, “high-speed networks”, and deploys technology to place orders and execute it as trades in a fraction of a second. This technology in the realm of securities has drawn notable consideration of investors and regulating bodies with respect to its responsiveness to the directives and accurate decision making which manually could have never been thought of and concerns regarding defeating fairness in the market respectively. Ever since COVID-19 has hit the Indian capital market, banking on technology to help sustain and fuel the growth would be a good call. However, it has its downsides and risks associated. Securities and Exchange Board of India (SEBI) as a regulating body has proposed measures, some of which might turn out to be far-reaching, while others might undermine the potential of HFT. This article attempts to highlight the opportunities and obstacles algorithmic trading is chained with. While discussing it the article tries to emphasize how the most controversial form of algorithmic trading can be appreciated and adopted by the market players to triumph over the menace of COVID.
Benefits and Obstacles of HFT
The advent of technology in the stock market has had many benefits over the years. HFT has played a huge role in improving the traditional market quality measures like depth and liquidity; it has the potential to reduce market volatility and trading costs. HFT has had an important role in reducing the bid-ask spread and tends to skim less off each trade when compared to old school market makers. It is a competitor to itself and therefore the claims that it will make markets one-sided is false. Markets are always fixed in favor of those with the best information and it is with the enhanced use of computers that the informational advantage has somewhat been neutralized.
Academics are divided about whether HFT is beneficial or harmful. There is a potential to lose control of computers. There have been instances of software malfunctions that have wiped off millions from the market within hours. The high speed of HFT also raises the potential for more vigorous market manipulation and acts like spoofing. Many contend that HFT provides pseudo-liquidity to the market. Others believe that HFT only operates for short term profit and has no meaningful contribution to the markets. There are various ways to keep HFT in check and reduce the risks associated with it and a lot of these have already been put in place or are being used in markets and exchanges globally. Technological innovation is crucial for market development but there must be a simultaneous adoption of safeguards at the same pace as technology develops.
SEBI’s Functions as a Check Post
SEBI was established essentially to regulate the capital market of India. One of its primary functions under section 11 (e) of SEBI Act, 1992 is, prohibiting fraudulent and unfair trade practices associated with the market. In pursuant to that SEBI has released numerous guidelines addressing the potential threats and widespread concerns of HFT since 2012, the latest of which came in June 2020; to regulate the functioning of HFT in the Indian capital market. It strives to set up a level playing field for the market players.
At the very outset, the discussion paper has identified the following proposals:
- To hold back the algo traders from placing huge orders and canceling them within a very short span of time, it has introduced a “minimum resting time” with respect to orders taking place through HFT. Resting time appertains to the period between the actual execution of the orders and the receipt of the orders by the respective exchanges.
This step shall lower down the instances of frequent cancellation of orders by the traders that intends to create phantom liquidity in the.
- Co-location is one of the major advantages of HFT where traders are present in close proximity and the information and signals travel fast to the other trader. This has caused more harm than good since only a handful of the traders can afford this facility. To stricture such activity, SEBI has proposed to match orders in a system where the exchanges would first accumulate all the orders for a specific duration of time later matching orders of that batch.
- The substantial difference which this technology has given rise to is with respect to time. Transactions are completed within a blink of an eye, which seems to be unattainable if the trading is restricted to human intelligence. To make sure that speed, as a discrete strategy does not help, SEBI has suggested incorporating a delay of few milliseconds while the processing of orders is in transit. This would hardly affect the non-algo traders. However, authors believe that time plays a significant role in algorithmic trading, and measures that defeat the purpose of bringing technology into use might discourage the traders involved in HFT.
- A large number of orders take place and are canceled the next moment. SEBI proposes to limit the Order to Trade Ratio (OTR). It refers to the ratio between orders taking place, modifications, and cancellations to the actual execution of orders that generates confirmed trades at any exchange. For securing a minimum of one trade for a set of orders, capping on OTR is suggested. Traders exceeding the ratio shall be penalized while placing the next set of orders.
SEBI has taken drastic steps to curtail the shortcoming of HFT. However certain proposals in the discussion paper have overshadowed the incentive of time enjoyed by the users of HFT and should also take the prospect of issues like insider trading associated with algo trading into consideration. Any set of regulations shall strive to provide a comprehensive solution, which while addressing the potential threats simultaneously, preserve the quintessence of HFT.
The Road Ahead
The rise of HFT has also brought with it a lot of apprehension in people and this has resulted in the adoption of policies by governments worldwide with an intention to restrict HFT and gradually kill it by imposing taxes and curtailing its freedom. That people are afraid of change is not a new phenomenon but the course of action adopted in the present situation is not the answer. The wrongs that HFT has the power to commit are not new. They have existed for a very long time. Therefore, the contention that HFT brings a lot of wrongs like inequality, spoofing, market manipulation etc into the market is not well-founded. Several countries have gone the tax way, imposing taxes that have the potential to make use of HFT a not so profitable trade anymore. Others have tried to completely restrict HFT altogether. The high speed of HFT is seen as a threat to market stability by many. But, a recent submission by the US SEC stated that during the COVID-19 pandemic, when the NYSE moved electronic, there wasn’t a lot of disruption in market activity, and the US equity market operated without any major disruptions. Furthermore, the indices of the Indian exchanges have shown a general upward growth these past few months even when the pandemic was raging on. That there was a lot of market fluctuation is no news, but a major culprit in this regard was the political ineptitude of various leaders. HFT may have even played a stabilizing role in this pandemic; only with time will we get a clearer picture of what exactly HFTs did in the markets during this pandemic. The authors believe that there is a requirement for uniform laws with regards to algo trading in India. Right now, SEBI releases broad guidelines and leaves the rest to the exchanges to figure out. SEBI should formulate a proper code for algo trading that will be applicable throughout India. A strong set of rules and strict punishments will act as an important deterrent mechanism and can go a long way in preventing traders from misusing HFT. Circuit breakers have a very limited history but still have always provided us with positive results. These circuit breakers are already present in markets worldwide and can prevent panic selling if ever needed. While countries around the world have tried to put a noose around HFT, India has promoted it. And a lot of this is owed to SEBI and its progressive stance. It is urged that the pro-technology stand by SEBI should not be replaced by anti-HFT measures.